Interest Rates

Interest rates are the cost of borrowing money; more specifically, interest rates are the price of credit. They are sometimes defined as the “rent” on borrowed capital, or as a fee on borrowed capital. The rates vary depending upon the risk assumed by the lender of not being repaid the capital. Interest rates are charge in borrowing transactions. To make a loan there must be a borrower who wants to enjoy the use of the principal and a lender who is willing to risk his or her capital. The interest rate is composed of the opportunity costs, the risks of the lender, and general economic conditions. The interest charged may be called interest, or sometimes it is masked as a fee.

One of the justifications for the charging of a fee on borrowed capital is that it makes up for the lost opportunities for investment incurred by the lender. The opportunity costs are experienced by the lender, who is compensated by the fee that is paid for the use of the capital that must be returned. According to this line of thinking, borrowing money and paying interest on those funds is analogous to renting an automobile and paying a fee for its use.

Types and Definitions

There are several types of interest. Simple interest is calculated on the principal or on the amount that remains unpaid. It can be illustrated by drawing a rectangle with interest and principal on the side of the rectangle and the years to pay along its bottom. Then the rectangle is divided from the upper left to the lower right. The area above the line represents the amount principal that has been paid. The area below the line is the amount of interest paid. By the end of the loan most of the payment is going for the return of principal with most of the interest paid in the early years of the life of the loan. In effect the total amount of interest is calculated as a part of the total to be repaid along with the return of principal. This is different from compound interest, which involves charging interest on interest.

Compound interest allows interest to be accumulated as an addition of the principal. It causes rapid growth in the sum of money that has to be repaid. In addition the time periods for compounding may be daily, weekly, or for a longer period of time. Thus, if a borrower has a loan of $1,000 and a compound interest rate of 1 percent per week, then the loan's balance at the end of the first week would be $1,010. Then at the end of the second week it would be 1 percent added to $1,010, which equals $1,020.10. At the end of the third week the amount would be $1,030.30. The resulting progression causes the principal to increase rapidly, making the cost of borrowing much higher than with simple interest.

Prior to the advent of computers several rules of thumb were used for calculating interest and principal repayment schedules. One was the now outlawed “rule of 78”. Another rough rule is the “rule of 72,” which allows mental math by dividing the interest rate into 72. So if the rate is 7 percent then the amount of time for the lender to double the amount lent is 7 divided into 72 which is a little more than ten years.

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